This revelation spawned outrage among folks who are sick of getting screwed by Wall Street. And in the wake of this criticism, not surprisingly, Wall Street began to defend itself.

One anonymous Wall Street investment banker, for example, lashed out at Nocera and me, branding us "ignorant sluts." And he then trotted out some standard sophisticated arguments to defend the LinkedIn mispricing.

These "pro-pop" arguments are nothing new, and they're bogus. But they appear to have again persuaded some smart people that IPO pops are good, so they're worth addressing directly.

I USED TO THINK "IPO POPS" WERE GOOD, TOO...

Before I address these arguments, though, it's also worth providing some background: I worked on Wall Street in the 1990s, as both an investment banker and a stock analyst. I watched hundreds of companies go public, and I participated in the underwriting of dozens of IPOs. As a banker and analyst, I made some of the same "pro-pop" arguments that the anonymous investment banker is making now. These arguments were self-serving for me and the firms I worked for (the view that big "pops" are good makes life a lot easier for Wall Street bankers), but I also believed them. It wasn't until after I left Wall Street and studied how much the IPO process actually costs companies that I began to realize how "IPO pops" screw the companies bankers are supposed to be acting on behalf of.

One thing I want to be clear about: I do not think LinkedIn and other companies with big IPO pops got "scammed" by their bankers. I don't think the banks intentionally mispriced the deals just to favor their investor clients and themselves (via the "over-allotment option" that allows them to buy 10% of the deal at the IPO price). But I do think the banks did a key part of their job badly, and I think companies should recognize that and hold them accountable for that.

Me in my analyst days.

The analogy I used last week to explain why "pops" are bad was that of a real-estate agent who persuades you to sell your house for $1 million and then then next day turns around and sells it to someone else for $2 million. If an agent did that to you, you'd be justifiably furious.

But the "pop" defenders argue that it's not at all similar because LinkedIn only sold a portion of itself. They continue this argument by saying that an IPO is a pricing event, not a fundraising event, so the actual amount of money raised is irrelevant. LinkedIn now has a public currency valued at about $90 a share, the pop-defenders say, so it doesn't matter what it sold those 10 million shares for.

This argument is ridiculous.

So what if LinkedIn only sold a "portion" of its stock? Why should it have sold this portion at a 50% discount to fair market value, when it could have sold it at only a 15% discount? By selling its stock at a 50% discount to the fair market value instead of a normal--and justifiable--15% IPO discount, LinkedIn and its selling shareholders gave away $200 million. And $200 million is real money, even if there's more where that came from.

In the interest of fully debunking this "only selling a portion of the stock" argument, let's change our real-estate analogy slightly. Instead of a house, let's say you're selling apartments in a new real-estate development. You have a building with a hundred apartments, all identical. After marketing your building, your real-estate agent proudly informs you that he can sell one of the apartments for $1 million. You say "Go for it!" The agent sells the apartment. And then the next day, the same real-estate agent re-sells the same apartment to someone else for $2 million.

I sold stock for $45 that was actually worth $90 and I'm supposed to say "Thank you"?

On the one hand, you're happy: You still have 99 apartments that you now realize have a fair-market value of $2 million apiece. But you also realize what just happened: The fair-market value of your apartments is $2 million. Your real-estate agent sold that first apartment to a good client at 50% off--and, in so doing, plucked $1 million out of your pocket and gave it to the client.

Importantly, your apartments were worth $2 million no matter what that first apartment sold for. Your agent selling your first apartment for $1 million did not affect the fair-market value at all.

So, the "portion" argument is bogus, but there are three other arguments/questions that are worth addressing here.

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The real estate analogy does not maintain: the buyer-agent-developer relationships are very different in terms of pricing/quantity/frequency of transaction.

The better analogy would be in the art or collectible world. Dealers have two constituencies, make their best estimates as to what is in each party's long-term interests, and play accordingly. On occasion, "bargains" will occur for one party or the other, but in generally the multi-stage game and the impact on dealer reputation cause them to seek fair outcomes to both sides in aggregate.

In the case of IPOs, this will be the last IPO that LinkedIn does, (though it may not be the last equity offering). It is but one in a series of IPOs that the bankers will bring to market, and but one in a series of IPOs that the institutional firms will purchase.

In a multi-stage game, the I-banks need to ensure that their repeated buyers will come back to the market, which they will do if their aggregate performance in purchased IPOs is attractive, and will not do if their aggregate performance in repeated IPOs is unattractive.

So from a game theory perspective, the rational I-bank seeking to maximize their own utility ought to bring to market the largest number of deals possible consistent with:
- not bringing IPOs to their customers that will have significant immediate downside, thus harming the I-banks reputation with its buyers
- will, in aggregate, perform attractively for their institutional clients so as to ensure continuing buyers
- not price IPOs in such a way that the I-bank acquires a differential reputation for under-pricing offerings, thus leading to a reduction in deals secured

All of which is a long-winded way of saying that IF an I-bank could accurately predict that there will be a big pop AND they can persuade the offerer to issue at a price that will provide the pop AND they do not do so often enough to acquire a reputation among potential offerers for being under-pricers, it is in their rational long-term interest to do so.

That being said, I doubt most capital markets groups actually have the capability to accurately predict the future and therefore do not actually know when they have a 'poppable' stock offering on their hands. It feels more like dumb luck.

Agree with all of this, Marc, but it still doesn't justify a 50% discount. All the same logic holds true with a 10%-15% discount, too.

When TheLadders goes public, you deserve to get close to a fair-market price, and so do your selling shareholders. Don't let your bankers persuade you that it doesn't matter what they sell the stock for. That makes their job way too easy.

Do you think the bankers "knew" they had $95 stock on their hands? I don't.

And I don't know why, rationally, they would price at $42 if they thought they could get twice that, because that would mean twice the commissions for them, making bonus season that much more attractive.

I have to agree with Henry on this one. The point that seems to be lost in the shuffle here is that the I-bankers are paid some pretty big money to have an idea where the demand will be and near what price the offering will clear. They are underwriting the offer, so don't for a minute believe that they are not talking with their sales desks every 20 minutes or so before the pricing asking, 'how is your book and how is the demand?'

It is possible that there is some surprise and some deliberate underpricing to give a 10-20% pop as Henry suggests, but a 50% or so pop should be unacceptable to the IPO issuer.

Yes, they have to make sure it sells so they will price it under a level where it will clear, but there is NO WAY that they would be "surprised" by a 50% or higher pop because they know going into the pricing what the demand is.

As Henry states originally, this is just a gift from LinkedIn to its underwriters which then in turn makes a gift to the Fidelitys et al of the world, in order to insure that Fidelity will buy the next underwriting from the same I-banks. This may be in the I-banks 'rational self-interest' , but the IPO company rightfully should be furious. And frankly, I believe this is the sort of thing the SEC should be looking at. They are concerned about insider trading ruining the game for the retail investor, I really don't see how this is different.

To follow up on your followup to Henry, "Do you think the bankers "knew" they had $95 stock on their hands? I don't....if they thought they could get twice that, because that would mean twice the commissions for them, making bonus season that much more attractive."

Not sure about that - what they may or may not have lost in some commissions, their trading desks could easily have made up with the stock they kept for their own account and with the greenshoe.

In addition, if they did not know, then HOW could they not know? Do you seriously believe that they do not have sales desks taking orders in advance of this pricing? They were either not honest with the IPO issuer LinkedIn, or they were not competent. Either outcome should be troubling.

The bankers never "know" anything (about prices). And market conditions can change fast. But when you do hundreds of deals, you have a pretty good feel. So I think it's fair to say they expected the stock to open above, say, ~$55, which is should have opened to support the $45 pricing.

On the "foregone fee," what everyone forgets is the "green shoe" over-allotment option. With IPOs, banks get the right to buy another 10% of the stock sold on the deal at the IPO price several days or weeks after the deal takes place. This is designed to allow the banks to sell stock they don't own to help stabilize the price (the banks make a market in the stock after the IPO).

When a deal is underpriced as badly as this one was, the overallotment option delivers huge profits to the banks. They will now buy another 1 million shares from LinkedIn at $45 and sell them immediately for $90+. That's a $45 million hidden gain.

And it's worth noting that it's a larger gain than the fee the banks will received, which is ~$30 million. And it's also much larger than the additional fees the banks would have gotten if they had sold the stock at, say, $60, instead of $45.